RATIOS UNDER FIVE

DIMENSIONS
 Liquidity Ratios

 Quick Ratio / Acid Test Ratio

 Current Ratio
 Cash Ratio

Liquidity indicate the company’s short-term financial position. Liquidity is a measure of

firm’s ability to pay operating expenses and other short-term, or current liabilities by current
asset.

Quick Ratio / Acid Test Ratio

Explanation
The quick ratio is a liquidity ratio that measures the ability of a firm to pay its current
liabilities when they come due with quick assets. Quick assets are the assets that can be
converted to cash within 90 days. Cash, cash equivalent, short term investment, or marketable
securities and current accounts receivable are considered as quick assets.
The acid test of finance is an indicator that show how well a company can quickly convert it
assets into cash in order to pay off its current liabilities. It also shows the level of quick assets
to current liabilities.

Formula

Current Assets−Inventories
Quick Ratio = Current liabilities

Analysis
The acid test ratio measures the liquidity of a company by showing its ability to pay off its
current liabilities with quick assets. If a firm has enough quick assets to cover its total current
liabilities, the firm will be able to pay off its obligations without having to sell off any long-
term or capital assets.
Since most businesses use their long-term assets to generate revenues, selling of these Capital
Asset will not only hurt the company but also the current operations aren't making enough
profit to pay off its current liabilities. So, higher quick ratios are more favorable for
companies at any time.

Current Ratio

Explanation
The current ratio is ratio that measures a firm's ability to pay off its short-term liabilities with
its current assets. The current ratio is an important measure of liquidity because short term
liabilities are due within the one year.
This means that a company has a limited amount of time in order to raise the funds to pay off
these liabilities. Current assets like cash, cash equivalent and marketable securities can easily
be converted into cash in the short-term. Companies with larger amount of current assets will
more easily be able to pay off current liabilities when they become due without having to sell
off long-term revenue generating assets.

Formula

Current Assets
Current Ratio = Current liabilities

Analysis
The current ratio help investor and creditors understand the liquidity of a company and how
to easily that company will be able to pay off its current liabilities. This ratio Expresses a
firm's current debt in terms of current assets.
A higher current ratio is also more favorable because it indicates that the company can more
easily make current debt payments. If a company has to sell of fixed assets to pay for its
current liabilities, this usually means the company isn't making enough from operations to
support activities. The current ratio also sheds light on the overall debt burden of the
company. If a company is weighted down with a current debt, its cash flow will suffer.

Cash Ratio

Explanation
The cash ratio or cash coverage ratio is a liquidity ratio that measures a firm’s ability to pay
off its current liabilities with only cash and cash equivalents. The cash ratio is more
conservative than other liquidity ratio because no other current assets can be used to pay off
current debt–only cash.
This is why many creditors look at the cash ratio. They want to see if a company maintains
adequate cash balances to pay off all of their current debts as they come due. Creditors also
like the fact that inventory and accounts receivable are left out of the equation because both
of these accounts are not guaranteed to be available for debt servicing. Inventory could take
months or years to sell and receivables could take weeks to collect. Cash is guaranteed to be
available for creditors.

Formula

Cash+ Cashequivalent
Quick Ratio = Current liabilities

Analysis
The cash ratio shows how well a company can pay off its current liabilities with only cash
and cash equivalents.

As with most liquidity ratios, a higher cash coverage ratio means that the company is more
liquid and can more easily fund its debt. Creditors are particularly interested in this ratio
because they want to make sure their loans will be repaid. Any ratio above 1 is considered to
be a good liquidity measure.
 Solvency Ratios

 Debt to Equity Ratio

 Debt Ratio
 Equity Ratio

Solvency indicates the overall financial position of a company. Solvency ratios are any form of
financial ratio analysis that measures the long-term health of a business. In other words, solvency
ratios prove (or disprove) that business firms can honor their debt obligations.

Debt to Equity Ratio

Explanation
The debt to equity ratio is a financial, liquidity ratio. The debt to equity ratio measures the
portion of company financing that comes from creditors and investors. A higher debt to
equity ratio indicates that more creditor financing (bank loans) is used than investor financing
(shareholders). Each industry has different debt to equity ratio benchmarks, as some
industries tend to use more debt financing than others.

Formula

Total Liabilities
Debt to Equity Ratio = Total Equtiy

Analysis
A lower debt to equity ratio usually implies a more financially stable business. Companies
with a higher debt to equity ratio are considered riskier to creditors and investors than
companies with a lower ratio. Unlike equity financing, debt must be repaid to the lender.
Since debt financing also requires debt servicing or regular interest payments, debt can be a
far more expensive form of financing than equity financing. Companies leveraging large
amounts of debt might not be able to make the payments.
From the view point of Creditors, a higher debt to equity ratio as risky because it is an
indication that the investors haven’t funded the operations as much as creditors have. In other
words, investors don’t have as much skin in the game as the creditors do. This could mean
that investors don’t want to fund the business operations because the company isn’t
performing well. Lack of performance might also be the reason why the company is seeking
out extra debt financing.

Debt Ratio

Explanation
Debt ratio is a solvency ratio that measures a firm’s total liabilities as a percentage of its total
assets. In other words, the debt ratio reflects a company’s ability to pay off its liabilities with
its assets. This also shows how many assets the company must sell in order to pay off all of
its liabilities.
This ratio measures the financial leverage of a company. Companies with higher levels of
liabilities compared with assets are considered highly leveraged and riskier for lenders.
This helps investors and creditors analysis the overall debt burden on the company as well as
the firm’s ability to pay off the debt in future, uncertain economic times.

Formula

Total Liabilities
Debt Ratio = Total Assets

Analysis
The debt ratio is a fundamental solvency ratio because creditors are always concerned about
being repaid. When companies borrow more money, their ratio increases creditors will no
longer loan them money. Companies with higher debt ratios are better off looking to equity
financing to grow their operations.

A lower debt ratio usually implies a more stable business with the potential of longevity
because a company with lower ratio also has lower overall debt. Each industry has its own
benchmarks for debt, but .5 is reasonable ratio.

Equity Ratio

Explanation
The equity ratio is an investment leverage or solvency ratio that measures the amount of
assets that are financed by owners to the total assets.
The equity ratio highlights two important financial concepts of a solvent and sustainable
business. The first component shows how much of the total company assets are owned
outright by the investors. In other words, after all of the liabilities are paid off, the investors
will end up with the remaining assets.
The second component inversely shows how leveraged the company is with debt. The equity
ratio measures how much of a firm’s assets were financed by investors.

Formula

Total Equity
Equity Ratio = Total Assets

Analysis
In rationale, higher equity ratios are typically favorable for companies. Because, higher
investment levels by shareholders shows potential shareholders that the company is worth
investing in since so many investors are willing to finance the company. A higher ratio also
shows potential creditors that the company is more sustainable and less risky to lend future
loans.

Equity financing in general is much cheaper than debt financing because of the interest
expenses related to debt financing. Companies with higher equity ratios should have less
financing and debt service costs than companies with lower ratios.
 Efficiency Ratios

 Account Receivable Turnover

 Asset Turnover Ratio
 Inventory Turnover ratio
 Days Sales in Inventory
 Days Sales Outstanding

Financial Efficiency is a measure of how efficiently company assets are being used to generate
revenue.
Account Receivable Turnover

Explanation
Accounts receivable turnover is an efficiency ratio that measures how many times a business
can turn its accounts receivable into cash during a period. In other words, the accounts
receivable turnover ratio measures how many times a business can collect its average
accounts receivable during the year. This ratio shows how efficient a company is at collecting
its credit sales from customers.

Formula

Net Credit Sales

Account Receivable Turnover =
Average Accounts Receivable

Analysis
Since the receivables turnover ratio measures a business’ ability to efficiently collect its
receivables, it only makes sense that a higher ratio would be more favorable. Higher ratios
mean that companies are collecting their receivables more frequently throughout the year.
Higher efficiency is favorable from a cash flow standpoint as well. If a company can collect
cash from customers sooner, it will be able to use that cash to pay bills and other obligations
sooner.
Accounts receivable turnover also is an indication of the quality of credit sales and
receivables. A company with a higher ratio shows that credit sales are more likely to be
collected than a company with a lower ratio. Since accounts receivable are often posted as
collateral for loans, quality of receivables is important.
Asset Turnover Ratio

Explanation
The asset turnover ratio is an efficiency ratio that measures a company’s ability to generate
sales from its assets. In other words, this ratio reflects how efficiently a company can use its
assets to generate sales.

Formula

Net Sales
Asset Turnover Ratio = Avgerage Total Assets

Analysis
This ratio measures how efficiently a firm uses its assets to generate sales, so a higher ratio is
always more favorable. Higher turnover ratios mean the company is using its assets more
efficiently. Lower ratios mean that the company isn’t using its assets efficiently and most
likely have management or production problems. This gives investors and creditors an idea of
how a company is managed and uses its assets to produce products and sales.
Inventory Turnover ratio

Explanation
The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is
managed by comparing cost of goods sold with average inventory for a period. In other
words, it indicates how many times a company sold its total average inventory dollar amount
during the year.
This ratio is important because total turnover depends on two main components of
performance. The first component is stock purchasing. If larger amounts of inventory are
purchased during the year, the company will have to sell greater amounts of inventory to
improve its turnover. If the company can’t sell these greater amounts of inventory, it will
incur storage costs and other holding costs.
The second component is sales. Sales have to match inventory purchases otherwise the
inventory will not turn effectively. That’s why the purchasing and sales departments must be
in tune with each other.

Formula

Cost of Goods Sold

Inventory Turnover Ratio = Avgerage Inventory

Analysis
Inventory turnover is a measure of how efficiently a company can control its merchandise, so
it is important to have a high turn. This shows the company does not overspend by buying too
much inventory and wastes resources by storing non-salable inventory. It also shows that the
company can effectively sell the inventory it buys.
Days Sales in Inventory/ Days Inventory Outstanding

Explanation
The days sales in inventory or days inventory outstanding measures the number of days it
will take a company to sell all of its inventory. In other words, the days sales in inventory
ratio shows how many days a company’s current stock of inventory will last.
This is an important to creditors and investors for three main reasons. It measures value,
liquidity, and cash flows. Both investors and creditors want to know how valuable a
company’s inventory is. Older, more obsolete inventory is always worth less than current.
The days sales in inventory reflects the scenario how fast the company is moving its
inventory.

Formula

Ending Inventory
Days Sales Inventory = Cost of Goods Sold × 365

Analysis
The days sales in inventory is a key component in a company’s inventory management.
Inventory is a expensive for a company to keep, maintain, and store. Companies also have to
be worried about protecting inventory from theft and obsolescence.
Management wants to make sure its inventory moves as fast as possible to minimize these
costs and to increase cash flows. Remember the longer the inventory sits on the shelves, the
longer the company’s cash can’t be used for other operations. It only makes sense that lower
days inventory outstanding is more favorable than higher ratios.
Days Sales Outstanding

Explanation

The days sales outstanding or average collection period measures the number of days it takes
a company to collect cash from its credit sales. This ratio shows the liquidity and efficiency
of a company’s collections department and shows how well a company can collect cash from
its customers. The sooner cash can be collected, the sooner this cash can be used for other
operations. Both liquidity and cash flows increase with a lower day’s sales outstanding
measurement.

Formula

Accounts Receivable
Days Sales Outstanding = × 365
Net Credit Sales

Analysis
The days sales outstanding formula shows investors and creditors how well companies’ can
collect cash from their customers. This ratio measures the number of days it takes a company
to convert its sales into cash.

A lower ratio is more favorable because it means companies collect cash earlier from
customers and can use this cash for other operations. It also shows that the accounts
receivables are good and won’t be written off as bad debts.

A higher ratio indicates a company with poor collection procedures and customers who are
unable or unwilling to pay for their purchases. Companies with high days sales ratios are
unable to convert sales into cash as quickly which indicates the poor performance.
Profitability Ratios

 Gross Margin Ratio

 Profit Margin Ratio
 Return on Assets
 Return on Equity
Gross Margin Ratio

Explanation
Gross margin ratio is a profitability ratio which is compared the gross margin of a business to
the net sales. Generally, the gross profit ratio is the percentage markup on merchandise or
inventory from its cost.

Formula

Grossmargin
Gross Margin Ratio = Net Sales

Analysis
Gross margin ratio is the indicator that how profitable a company can sell its inventory or
merchandise. Higher Gross margin ratios are more favorable because of the firm’s sells its
inventory at a higher profit and also it can help the firm’s more to pay operating expenses.
Profit Margin Ratio

Explanation
The profit margin ratio is a profitability ratio which is measured the amount of net profit
generated by the net sales of a company and shows the percentage of are remained after all
expenses are paid by company. This is the most important indicator for Creditors and
investors that how effectively a firm can convert its net sales to net income.

Formula

Net Income
Profit Margin Ratio =
Net Sales

Analysis
The profit margin ratio measures the efficiency of a firm how well manages its all expenses
related with net sales. Higher profit margin ratios are more favorable because investor wants
more profit and creditors want to get back its loan. If a firm has a higher profit margin ratio, it
indicates that the company will be able to satisfied its relative parties. Profit Margin Ratio is
also effective for measuring past performance of a company.
Return on Assets

Explanation
the return on assets ratio or ROA is a profitability ratio that indicates generate its
profit by making its assets productive. The return on assets ratio or ROA measures
how efficiently a firm can manage its assets to produce profits.

Formula

Net Income
Return on asset ratio =
Total Asset

Analysis
A higher Return on asset ratio is more favorable to investors because it shows that the
company is more effectively managing its assets to produce greater amounts of net
income. A positive ROA ratio usually indicates an upward profit trend as well. ROA
is most useful for comparing companies in the same industry as different industries
use assets differently. This ratio is the measure of how profitable a firm’s assets are.
Return on Equity

Explanation
The return on equity ratio or ROE is a profitability ratio which is related with company’s
ultimate goals. ROE is the most important indicator for investor and creditor that show ability
of a company to generate profits from its shareholders investments. Its an important measure
how efficiently a company’s management is at using their equity financing to fund operations
and grow the company.

Formula

Net Income
Return on equity ratio = Shareholders Equity

Analysis
ROE measures how efficiently a Company can use the investment from shareholders to
generate profits. ROE is a profitability ratio from the investor’s point of view. Investors want
to see a high return on equity ratio because this indicates that the company is using its
investors’ funds effectively. Before making investment, the New investor analyze ROE of the
company because its helps track a company’s progress and ability to maintain a positive
earnings trend and to make better investment decision.
Market Prospect Ratios

 Earnings Per Share (EPS)

 Price Earnings Ratio (P/E)
 Dividend Payout Ratio
 Dividend Yield
Earnings Per Share (EPS)

Explanation
Earnings per share (EPS) or net income per share, is a market prospect ratio that show the
amount of net income earned per share outstanding. Earnings per share is also an indicator
that shows how profitable a firm is on a shareholder basis. EPS is the most used ratio for
investor that is a snapshot of a company performance.

Formula

Net Income
Earnings per share (EPS) = NO . of common share Outstanding

Analysis
Earnings per share is the best element to understand a company performance at a glance.
Higher EPS is always better than a lower ratio because this indicates that the firm is more
profitable and it has more profits to allocates to its shareholders. Although many investors
don’t pay much attention to the Earnings per share because there are so many things can
manipulate this ratio, investors tend to look at it but don’t let it influence their decisions
drastically.
Price Earnings Ratio (P/E)

Explanation
The price earnings ratio or P/E ratio or price to earnings ratio, is a market prospect ratio
which shows what the market is willing to pay for a stock based on its current earnings.
Investors are usually use this ratio to appraisal what a stock’s fair market value should be by
predicting future earnings per share. The price to earnings ratio helps investors analyze how
much they should pay for a stock based on its current earnings that why this ratio also called
a price multiple or earnings multiple. Investors use this ratio to decide what multiple of
earnings a share is worth.

Formula

Market Value per share

Price Earnings Ratio (P/E)= Earnings Per Shares

Analysis
The price to earnings ratio indicates the expected price of a share based on its earnings. A
company with a high P/E ratio usually indicated positive future performance and investors
have higher expectations for future earnings growth are willing to pay more for this
company’s shares. On the other hands, a company with a lower P/E ratio, is usually an
indication of poor current and future performance. it’s quick and easy to use when investors
are trying to value a company using its earnings.
Dividend Payout Ratio

Explanation
The dividend payout ratio indicates that how much of net income that is allocated to
shareholders in the form of dividends during the period. In other words, dividend payout ratio
shows the portion of profits or net income the company decides to keep for operations and the
portion of profits that is given to its shareholders. Investors are particularly interested in the
dividend payout ratio because they want to know if companies are paying out a feasible
amount of net income to investors.

Formula

Total dividend
dividend payout Ratio = Net Income

Analysis
When investors want to see a steady stream of sustainable dividends from a company, the
dividend payout ratio analysis is important. A consistent trend in this ratio is usually more
important than a high or low ratio. Since it is for companies to declare dividends and increase
their ratio for one year, a single high ratio does not mean that much. Investors are mainly
concerned with sustainable trends

Conversely, a company that has a downward trend of payouts is alarming to investors which
is indicate that the company can no longer afford to pay such high dividends and this could
be an indication of poor operating performance. Generally, more mature and stable
companies tend to have a higher ratio than newer startup companies.
Dividend Yield

Explanation
The dividend yield is the ratio that is the measurement of the amount of cash dividends
allocated to common shareholders relative to the market value per share. The dividend yield
is used by investors to measure how their investment in stock is making either cash flows in
the form of dividends or increases in asset value by stock appreciation. Investors can use the
dividend yield to evaluate their return on investment in stocks.
Investors invest their money in stocks to earn a return either by dividends or stock
appreciation. Some companies choose to pay dividends on a regular basis (income Stock) and
some companies choose not to issue dividends and instead reinvest this money in the business
(growth stock).

Formula

Cashdividend per share

dividend Yield = Market value per share

Analysis
Investors use the dividend yield formula to compute the cash flow they are getting from their
investment in stocks. In other words, investors want to know how much dividends they are
getting for every dollar that the stock is worth.
A company with a high dividend yield pays its investors a large dividend compared to the fair
market value of the stock. This means the investors are getting highly compensated for their
investments compared with lower dividend yielding stocks. A high or low dividend yield is
relative to the industry of the company. Generally, investors want to see a yield as high as
possible.
 Du-Pont Analysis
The Dupont Corporation developed Du-Pont analysis in the 1920s. The Dupont analysis also
called the Dupont model is a financial ratio based on the return on equity ratio. The return on
equity ratio or ROE is a profitability ratio which is related with company’s ultimate goals.
ROE is the most important indicator for investor and creditor that show ability of a company
to generate profits from its shareholders investments. In other words, this model breaks down
the return on equity ratio to explain how companies can increase their return for investors.
This model was developed to appraisal ROE and the effects different business performance
measures have on this ratio. So, investors are not looking for large or small output numbers
from this model. Instead, they are looking to analyze what is causing the current ROE.

Du-Pont Analysis for Stylecraft Limited

Financial Statement information of Stylecraft Limited:

2018 (in Millions) 2019 (in Millions)
Revenue 3254.259 3519.776
Net Income 15.538 39.100
Total Asset 1305.191 1379.904
Shareholders Equity 294.493 333.593
EBT 42.450 62.425
EBIT 44.332 63.476

Following this information Du-Pont Analysis for Stylecraft Limited under

three components –
Formula for ROE,
ROE= profit Margin × Assets turnover × Equity Multiplier
Net Income Revenue Total Assets
= Revenue × Total Asset × shareholders Equity

ROE for two years,

2018 = 0.48% * 2.493* 4.432 = 5.28%
2019 = 1.11% * 2.551* 4.136 = 11.72%

Analysis
In 2019, Stylecraft Limited is able to generate higher sales due to maintaining a lower cost of
goods which is reflected by its high profit margin. On the other hands, assets turnover in 2018
slightly lower than 2019 which is indicates that the company isn’t using its assets efficiently
and most likely have management or production problems in this year. And also, debt
financing in 2018 is higher which is also affected on the return on equity.

Du-Pont Analysis for Stylecraft Limited under Five (05) components –

Formula for ROE,
ROE= (Tax Burden× Interest Burden × Operating Income margin × Assets turnover
× Equity Multiplier)
Net Income EBIT EBIT Revenue Total Assets
= × × × ×
EBT EBT Revenue Total Asset shareholders Equity

ROE for two years,

2018 = 36.60% * 95.75% * 1.36% * 2.493* 4.432 = 5.28%
2019 = 62.64%* 98.34% *1.80%* 2.551* 4.136 = 11.72%

Analysis
In 2018, Stylecraft Limited profit is highly affected by tax. But the opposite scenario is
shown in 2019. Both 2018 and 2019, interest expense is almost same. Stylecraft Limited
managed its costs and increasing its profit which is the indication of higher operating profit
margin in 2019 than 2018. In 2018, company maybe not efficient in convert revenue into
profit. And also, there is the possibility of high costs of goods sold or operating expenses.
Debt financing or financial leverage is higher that why company s profit is influenced by
interest expense which is reflected in ROE of 2018.